The formulas, tricks and trade secrets of Private Equity

Private Equity Risk Management Iso Principles

Sample Chapter

There can be a fine line between investing in great businesses and investing for investment’s sake. A great business may have risks, it may have question marks, but it only takes a handful of information and 30 minutes with the prospective manager to have that feeling. That feeling doesn’t negate the need for rigorous analysis, but it goes a long way to making sure you’re on the right track in terms of acceptable private equity risk management.

The purpose of this foreword is to propose that it is very easy to use a risk management strategy as a tool to justify a not-so-great investment. Private equity risk management is temporal; a valuation should be based on the risks of an investment at the time of the investment, not just what they’re planned to be at a later point in time. For example, if a business only offers one product, your valuation should be congruent with this concentration risk. Don’t pay a price that is contingent upon the acquisition of an unknown business that you expect to diversify the product base. If you’re doing the work to improve the business, why pay the vendor for your hard work?

The theory of private equity risk management requires (and deserves) a large tome. However, as an aside, I’d like to share the very basics of the risk management process. The steps in the process according to the International Standards Organisation, although slightly abridged, are as follows:

  1. Establish context: understand the situation and the need for adequate risk management. In a private equity context, realise it is linked to price and performance and is a prescient concern.
  2. Identification: think about objectives, scenarios, best practice, etc. to identify the risks that are present. Look at other businesses and their risks to ensure you’ve been exhaustive.
  3. Assessment (analyse and evaluate): analyse the risks and understand their likelihood, impact, sources, consequences, etc. Evaluate this data to prioritise the mitigation of the risks.
  4. Treatment (plan, implement, review): create a plan to treat the risks, but remember treatment means treating them now, not in the future. Implement the treatments and review success. Ensure that a variety of objective people agree with the treatment and the perceived results.

I hope this has helped, but more critically, the purpose of my post was to propose that private equity risk management is temporal. Planning to ameliorate a risk in the future doesn’t mean you have managed it now. Also, invoke an iterative risk management process and be diligent about the entire concept. After all, it can literally mean the difference between a horrific failure and an outstanding success.

I found the ISO principles for private equity risk management while conducting research and thought they may prove useful in jerking one’s memory when conducting a risk assessment. On reflection, some of them sound a little too bureaucratic to me, but most are worth the effort.

  • Risk management should create value
  • Risk management should be an integral part of organizational processes
  • Risk management should be part of decision making
  • Risk management should explicitly address uncertainty
  • Risk management should be systematic and structured
  • Risk management should be based on the best available information
  • Risk management should be tailored
  • Risk management should take into account human factors
  • Risk management should be transparent and inclusive
  • Risk management should be dynamic, iterative and responsive to change
  • Risk Management should be capable of continual improvement and enhancement

I’ve said it many times before, but private equity is about risk management (or value preservation) first and value creation second. It is unnecessary to take undue risks, especially when the mid-market end of the industry has access to so many different opportunities.

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